Updated 12/1/09 with comments on GE Capital and rewording of section on Hartzell Long/Short LLC.
David C. Hartzell is the owner and portfolio manager of Buffalo, NY based Cornell Capital Management, a private investment management firm that custom designs investment portfolios for small to midsize companies and high net worth individuals. He also runs a hedge fund, Hartzell Long/Short LLC.
We asked David to share his highest conviction stock holding in his portfolios, and he chose General Electric (GE). This is particularly interesting given the fact that prior to founding Cornell Capital in 1991, Mr. Hartzell worked for GE for a number of years in various capacities. Here's David's investment thesis:
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My highest conviction pick is GE. General Electric's financial position remains strong, despite the company's loss of its AAA rating early in 2009. Its profit margin was 9.54% and the ROE was 16.4% in 2008. GE had $48B in cash on the books at the end of 2008, and that number has increased to more than $57B as of third quarter 2009.
If I had to bet my life that one stock on the NYSE would rise over the next 12 months, it would be GE. Other stocks will have more of a percentage increase, but GE is the one stock you can bet the farm on.
How much is this an industry pick as opposed to a pure bottom-up pick?
It’s both. GE is an industry pick because they do so many things well. Most of their divisions would be competitive, Fortune 500 companies if they were free standing entities. They just happen to be wrapped in a larger whole.
GE is also a bottom-up pick because Wall Street has largely discounted GE. While many still think of GE as washers, dryers and light bulbs, the consumer and industrial division is one of their smallest in terms of size and profit contribution. In 2008, Consumer and Industrial products contributed $11.7B in revenue to GE’s bottom line, just 6% of GE’s total revenue. This sounds like a lot of money, but you need to compare it to other divisions within GE to get an idea of the scale that GE works on. For example, technology infrastructure contributed $46.3B and Energy Infrastructure contributed $38.5B. While Consumer and Industrial contributed 3.1% in margin, Technology infrastructure stalwarts like aviation contributed 19.1% margin, transportation contributed 19.2%, and NBC contributed 18.5% margin. You can see why GE wants to sell the Consumer and Industrial group in favor of adding more businesses in aviation and transportation. Not only are the revenues higher, but the margins are too. GE has been active in the cost cutting department over the last 36 months. In addition to the $2.2B that was spent in corporate restructuring during 2007 & 2008, GE plans to spend another 1.6B in 2009 alone. These restructuring actions should significantly boost 2010 EPS growth.
How would you describe GE's competitive environment? How is GE positioned vis a vis its competitors?
While Jack Welsh was at GE, they tried to be #1 or #2 in all of their businesses. This thinking keeps GE competitive in all they do, and the current leadership is not afraid to jettison business groups if they feel that the business is not an excellent ongoing fit.
The difference with GE is that they have the throw weight to enter and dominate a given business with the size of their acquisitions. While other companies may be happy with a toehold in a complex business, and be content to slowly grow their market share over a period of years, GE has the free cash flow to be a dominant player - immediately - in any arena they choose to do battle in. Or not. GE has the luxury of throwing away businesses that many would kill to own because they are not profitable enough, either in terms of gross revenue or margin contribution.
For example, few would argue that the GE appliance business, which is part of the Consumer and Industrial division, is the #1 or #2 appliance business in the US. That said, it doesn’t bring in a lot of revenue and even less margin than many other GE businesses. GE has been trying to sell it for years and as soon as they find a buyer, out it goes. NBC is a solid business, generating over $16.9B in revenue and $3.1B in profit at 18.5% margin in 2008. Nice! Many companies would love to add a division like NBC to their mix (Comcast is one of them) but GE is betting it can use that cash to build on the base it already established or to add new businesses that contribute both additional revenue and enhanced margin. This has been the strategy for the last four or five years, and has worked… sometimes. GE has scored with winners like Enron Wind and Smith Areo, and suffered with losers like Interlogix and Edwards. We applaud them for their recent joint venture with Shenhua Group Corp. to develop "cleaner coal" technology in China.
While GE only received 4% of its revenue from China in 2008, the company is committed to doubling that number over the next five years. Despite the worldwide recession of 2008, China is currently outspending all other nations in infrastructure construction spending. GE has one of the highest exposures to infrastructure in the S&P 500. This puts GE in exactly the right place as the world builds out. This trend will continue over the next twenty years, and GE will be right in the middle of the mix. GE has made the decision to focus on emerging markets that have a much higher growth rate than developed countries where they currently do business. Exposure to these second and third world nation’s plays to GE’s strength in infrastructure development and technology; size and access to a variety of industry products also helps the GE brand on a worldwide basis. If you look at India and China, GE can supply hundreds of different product lines including locomotives, healthcare, energy, aviation, nuclear, wind, and perhaps most importantly, water. In 2008, about twenty eight percent of GE Industrial's revenue came from emerging regions. We expect this to increase to greater than forty percent by 2012.
But what about GE's troubled finance division?
When the golden boy falls, it’s a long way down. GE Capital was once the most aggressive, progressive and far and away the most profitable division of the General Electric Company. There is no doubt that GE Capital took a hit in 2008. The question is, can it bounce back to some semblance of its former self?
First, the upside…
1. GE Capital consists of 5 divisions: Commercial Lending and Leasing, GE Commercial Aviation Services, GE Money, Energy Financial Services, and Real Estate Financing. It may come as a surprise to many that all five were profitable in 2008.
2. As of third quarter 2009, only Real Estate was unprofitable, and we expect this division to return to profitability by 2012-2013.
3. GE Money’s delinquencies (4.78% at 3Q09 end vs. 4.71% at 2Q09 end) have slowed to a crawl.
4. In a difficult business environment, originations remain strong and that augurs well for 2010.As of third quarter 2009, recent GECS deals have a normalized ROI of 2%+, bolstered by increasing margins during recent deals to about 3%.
5. GE Management has approved $0.4bn of restructuring actions for 4Q09.This will enhance the profitability of GECC in 2010-2011.
6. The Commercial Finance portfolio quality deterioration has eased as of 3rd quarter 2009.
7. As the bleeding slows down at GE Capital, the need for external capital infusions from the parent decreases.
8. GE Money's non-earnings (8.80% at 3Q09 end vs. 8.73% at 2Q09 end) once thought to be headed to 10%, are up, but not meaningfully so.
9. GE Capital will benefit from a lower cost of funds due to government backed TLGP.
10. Although the Government could force GE Capital to split from the parent, we do not see this scenario panning out in the near future.
Then, the down side…
1. GE Capital knows a lot more about their business (how big are the skeletons? where are they buried?) than you and I. That's why they tapped the parent for billions last year and put a plan in motion to borrow billions more if necessary.
2. Pre-tax impairments rose during the third quarter from $291M. to $467M.
In conclusion, GE is in the process of shrinking GE Capital. While a smaller, safer GE Capital is good for GE, GE Capital will never be the revenue generator that it once was.
At one point, GE Capital was providing over 1/3rd of GE’s total earnings. Receivables have fallen from a peak of $428B during 2nd quarter 2008. We estimate that GE Capital will ultimately take their receivables to about 250B, a level that both GE Capital and the Parent seem to feel comfortable with. As GE Capital grows the equity buffer it needs to thrive, it will again start paying dividends to the parent.While GE Capital suffered along with the rest of the industrial and financial world in 2008, it is too early to count out this once mega-profitable division of GE. We expect GE Capital to return to full profitability by 2012.
Can you talk about GE's valuation - and how that compares to its competitors?
We feel that most analysts have failed to see the whole picture at GE, and have sold the company short. Lately GE has been trading in line with financials like Citigroup (C) and Bank of America (BAC), Wells Fargo (WFC) and JPMorgan Chase (JPM). We feel that GE’s valuation should reflect its diverse industrial and service base, so comparisons with companies like Phillips (PHG) or Seimens (SI) in Healthcare, Boeing (BA) or Pratt & Whitney (UTX) in aviation, Honeywell (HON) or Rockwell Automation (ROK) in Enterprise Solutions) and Disney (DIS) or Time Warner (TWX) for comparison to NBC would present a more accurate picture of the financial prospects of the corporation.
Using a sum of the parts analysis, GE could trade as high as $22 per share over the next 24 months.
What is the current sentiment on the stock? How does your view differ from the consensus?
While the consensus is GE $13-$15, that is slowly changing. Bernstein Research raised its rating from market-perform to outperform on November 6th. They set a $19 price target on GE. We feel that they are the first, but certainly not the last, to upgrade GE. One of the drawbacks for many analysts is the uncertainty surrounding the sale of NBC to Vivendi SA (VIV.FR). GE is still negotiating with Vivendi SA to buy Vivendi's 20% stake in NBC Universal. CFO Philippe Capron stated that “We are not interested in staying onboard a new GE-Comcast ownership of NBCU... we will exit and it will give us more headroom." The upside is that many of the details have already been worked out. In fact, General Electric and Comcast have agreed on a structure for the board of a new NBC Universal joint venture, Reuters reported on November 14th.
Does the company's management play a role in your position?
Yes. We feel that the GE management team is one of the best in the business. This is true not only at the top; the managers at the bottom of the pyramid are excellent as well. GE is one of the few companies that actively encourage their managers to continue their education. While many pay lip service to the concept of advanced education, few actively encourage it. If you are currently working at the director or vice president level, try asking for time to work on your MBA. The current task or tasks always come first, education last at most American companies. GE is different. For more than 50 years, the Crotonville campus has been at the forefront of real-world application for cutting-edge thinking in organizational development, leadership, innovation and change. If you have excellent managers, train them continuously, and offer them to the chance to stay on the cutting edge of their profession by continuing their education, they will work harder, smarter and make better decisions (over the long term) for the company than managers whose learning stopped when they graduated from college.
What catalysts do you see that could move the stock?
- Continued positive earnings
- Revised forward looking estimates by analysts as the business climate improves
- A continued improvement in the economy, with emphasis on the commercial real estate market.
I know that you manage money (Cornell Capital Management) and trade in your hedge fund (Hartzell Long/Short LLC). Where does GE fit in?
All of the clients that I manage money for have GE in their portfolio. Although I stopped buying GE several years ago when it was $40 per share, I jumped back in early in 2009 when it bottomed out, then rose to $10 per share. For clients who have a long term, buy and hold mentality, GE will provide a handsome return over the next 5-10 years.
I love to trade GE in my hedge fund… it’s so predictable. There are other stocks that have bigger intra-day gains, and other hotter stocks that will gain much more over the next 12 months, but GE fits in extremely well with what I do. The one lesson I have learned over the last 36+ years is it really doesn’t matter how much you make in November if you give it all back in December. With age comes wisdom (one would hope). I am more than willing to give up the top to protect the bottom.
What could go wrong with this stock pick?
As the economy goes, so goes GE. Their hodgepodge/polyglot/cross-section of American business makes GE a bellwether on the state of the American economy. If the economy does not improve over the next 12-18 months, and if we get a second dip that is much bigger than the first, then GE will tank along with the rest of the economy. But I don’t see this happening.